Supply Shocks and the Conduct of Monetary Policy Takatoshi Ito As I see it, everybody else has considered this problem. The supply shock is a major challenge to an inflation targeter. It has been agreed that against demand shocks, the inflation targeting is a powerful framework. But probably we have not seen the serious challenge to the inflation targeting framework by supply shocks. Probably the oil price increase in the last year and a half posed some modest challenge to inflation targeters but since we started from very low inflation, it was not really a challenge. Just flipping through Governor Tetangco’s slides, I am sure he will be very elaborate on details of the supply shocks and effects on monetary policy so I will not go into those details. Let me talk about how I think the importance of establishing the inflation targeting framework before supply shock really comes. I still think that inflation targeting is a powerful framework, even against supply shock in addition to demand shocks. The power of inflation targeting framework is that it is to maintain inflation expectations of the public even if you are deviating from the targeted inflation rate. So we discussed about missing targets and so on in the morning session, but the powerful test about whether your inflation targeting framework is successful or credible is, when you deviate for good reasons from the target, does the inflation expectation stay constant? I think this is a good test of the credibility and the success good performance measure of the inflation targeting framework. When you have the negative supply shock, your output goes down and your inflation goes up – the situation known as stagflation. You do not want to be an inflation nutter, to the point that you would kill inflation and keep the inflation target at all costs. You want to accommodate and you want to smooth the output, but you know that you want to go back to the inflation rate target in the medium run. You want to deviate in the short run because the output loss will be tremendous if you are an inflation nutter. Being an inflation nutter means you always target inflation at π* – i.e., inflation remain at target all the time for any cost. You do not want to be an inflation nutter. You want to accommodate. You want to have a way to mitigate supply shock and to avoid huge output loss. On the other hand, it will be a disaster if the public changed their expectations as a result of policy accommodation, as inflation rate would be higher than the target. If the accommodation changed the public expectations, resulting in a wage increase and leading to the second round inflation, that would be disaster. The power of the inflation targeting framework 1 is that the public trust you. The public believes that you will go back in the medium‐run to the target inflation rate so that they regard this partial accommodation will be temporary so inflation expectation does not change, and you have time to adjust real economy side so your inflation rate will go down in the medium run. So I would not advocate the inflation targeter to be an inflation nutter. I will be more pragmatic; when the bad supply shock comes, you should allow inflation to go up slightly and moderate output loss. I would emphasize the framework credibility and partial accommodation against adverse supply shock. 2 Supply Shocks and the Conduct of Monetary Policy in the Philippines Amando M. Tetangco, Jr. I will divide my presentation into four parts. First, I will talk about the operational details of our own inflation targeting in the Philippines and then I will move on to some policy issues related to dealing with supply shocks. Then in the third part, I will talk about our experience in dealing with the supply shocks under an IT framework. And then I will give my concluding remarks after that. Let me begin with how we came to adopt inflation targeting. The idea to adopt this framework in the Philippines was first considered by policy makers in the late 1990’s. Much like our counterparts in other developing countries at that time, monetary authorities in the Philippines were trying to cope with the macroeconomic impact of financial liberalization which appeared to have weakened the relationship between money on the one hand and inflation and output on the other. The limitations of monetary targeting as a framework were highlighted by the country’s experience in the 1990’s. Monetary targeting relies on a precise relationship between money and inflation and in the 1990’s, financial liberalization affected that relationship and we saw a weakening of that relationship. Money demand became more volatile in the short run, mainly because of rapid developments in financial intermediation which took place alongside recurrent macro economical cycles and financial crisis. Then, we had an IMF program at that time and we observed that sharp increases in money supply did not translate into higher inflation. For example, the sharp rise in liquidity in 1994 and 1995 due to a surge in capital flows was accompanied by a deceleration in inflation from about 9% to slightly over 8%, during those two years. The absence of a pick up in inflation in the presence of historically high rates in liquidity growth suggests a structural break in inflation dynamics. Moreover, under the IMF program at that time, there was an adjustment made in the performance criteria, such that an increase in liquidity arising from increase in capital inflow could be accommodated in the targets for as long as inflation did not go up by a certain percentage. So that was an adjustment that was introduced. On the whole, the reduction of the information content of monetary aggregate was evident even the movement of prices and the movement of liquidity. This had limited their effectiveness both as a level of monetary policy 3 as well as an indicator of the monetary stance. So against this backdrop, inflation targeting was seen as an effective way for the BSP to resolve policy dilemmas from multiple objectives, and also to establish credibility in committing to low inflation over the medium term. Here are the operational details under our inflation targeting framework. Our mandate under the law clearly specifies price stability as the main objectives of policy and inflation target is a range target for headline inflation averaged over the calendar year with a width of 1%. I think, this morning, there were some observations that this is probably too tight and in fact we recently had the review of the operational procedures for our inflation targeting framework by a panel of international experts and indeed they made the same observation and we are now in the process of shifting from a range target to a point target with plus or minus 1%, effectively widening the range for our inflation target. The main policy instrument used for policy decision is the overnight repo rate, or reverse repo rate while policy decision on the monetary policy stance being made by the monetary board which meets once every 6 weeks. Now before this meeting, there is a meeting of the advisory committee which submits its recommendations to the monetary board. This advisory committee is composed of senior officials of the BSP together with the Governor as the chair of that committee. Our transparency mechanisms consist mainly of quarterly inflation report, press releases on monetary policy, and the minutes of the main monetary board meeting which are released after a period of four weeks. In terms of the accountability mechanism, we have to provide an open letter to the President in case the target is breached whether it is on the downside or the upside and this letter is usually published in January soon after the full year inflation rate for the preceding year has been made available by the statistical authorities. There is another body in the Government that produces the inflation data, the CPI, and we rely on that for the actual numbers on price movements. We also make use of escape clauses, or what we refer to as exemption clauses, just like other inflation targeters, but we would rather use exemption because of the somewhat negative connotations of escape clause! So we introduced that little change earlier in the game. And as you can see, exemption process relates mainly to supply shocks involving food and energy prices as well as changes in the tax regime. In considering the monetary policy stance, the Monetary Board looks at a wide array of economic data, but the most important factor is the assessment of the likely evolution of inflation risks over the policy horizon of two years. This is an inflation outlook as embodied in our own forecasts of inflation. In addition, we also look at the evidence of demand side inflation pressures and adverse shifts in inflation expectations. Dr. Ito made reference about inflation expectation and we 4 will take this up a little bit later in the presentation. We likewise monitor development in the credit conditions in order to avoid a potential build up in credit activity. The monetary assessment process relies on a number of quantitative tools for forecasting, estimating the risk of a currency crisis or exchange market pressure and gauging public inflation expectations via survey based data such as our quarterly business expectation survey and consumer expectation survey. The business expectation survey was started about two years ago and the consumer expectation survey about a year ago. So the data available from these surveys is still quite limited but I think as we move along, we can build up additional data that would make these even more useful down the road.